Early Distributions From Retirement Plans

Here’s a lesson to be learned: If you don’t have a good excuse, you just can’t deposit early distribution proceeds from a retirement plan into your savings account and use them however you want—without paying a price. Unfortunately, the petitioner in William K. McGraw v. Commissioner, T.C. Memo. 2013-152 (June 17, 2013), didn’t heed that warning.

Along Comes Baby

In 2009, petitioner William McGraw wanted to move his retirement annuity account from ING USA Annuity & Life Insurance Co. into a “better performing annuity.” He relied on the advice of an acquaintance, who liquidated the account and presented William with a check for $67,440. William was a bit upset that the amount was substantially lower than what he thought the account was worth. Nonetheless, knowing that a rollover hadn’t occurred (and instead of rolling the proceeds into a new account), William deposited the check into his regular bank account. He actually considered himself lucky that his acquaintance never completed the rollover, because William learned shortly thereafter that his wife was pregnant. Because William’s wife’s first pregnancy was difficult, he believed that depositing the check might come in handy if he needed funds to defray pregnancy-related expenses. William and his family had medical insurance coverage through United Healthcare.

William’s wife had some complications during her pregnancy and was hospitalized on Dec. 4, 2009—the day their baby was born. She returned to work in mid-2010, in part because she needed to recover from her Caesarean section and in part because she wanted to stay home and take care of their children.

No Exceptions

For the year 2009, William failed to include in gross income the distribution of $67,440 from his retirement plan. The Internal Revenue Service issued a notice of deficiency under Internal Revenue Code Section 72(t)(1), which imposes an additional 10 percent tax on an early distribution from a retirement plan, subject to certain exceptions. William satisfied no exceptions. Here’s why.

First, William was not 59½ years of age at the time of the distribution, so the exception under IRC Section 72(2)(A) didn’t apply. Second, the distribution wasn’t used for “medical expenses,” an exception that appears in IRC Section 72(t)(2)(B). While the court fund that William and his family did incur pregnancy-related expenses during 2009, William failed to substantiate any particular amount through any documentation. He reported no medical expenses on his Form 1040 Schedule A. And, his best recollection was that the total out-of-pocket pregnancy-related expenses were in the range of $5,000 to $6,000. When the court asked him what he spent the remainder of the $67,440 retirement distribution on, he replied that he prepared a room for the baby and used the funds “for all the baby things that you do.” Third, even if the expenses were qualified medical expenses, William didn’t show that they were unreimbursed. In fact, he testified that although he had medical insurance, he didn’t know the extent to which the costs were paid for by the insurance company. Finally, even if William documented unreimbursed medical expenses, the amount wouldn’t exceed 7.5 percent of his adjusted gross income—which is the statutory floor imposed by IRC Section 213. Thus, $23,659 federal income tax was due.

Accuracy-Related Penalty Applies

Under IRC Section 6662, a 20 percent penalty will apply to the part of an underpayment that’s attributable to a substantial understatement of income tax. “Substantial” is defined as exceeding the greater of 10 percent of the tax required or $5,000. William’s notice of deficiency determined an understatement of income tax in excess of $23, 000—way above $5,000 and 10 percent of the total tax required.

William attempted to convince the court that under Higbee v. Comm’r, 116, T.C. 438 (2001), he had “reasonable cause” for the underpayment and he acted in “good faith.” Unfortunately for William, he failed on both accounts. William used a professional tax return preparer in connection with his 2009 tax return. He didn’t receive advice from his preparer (or anyone else), that an early distribution of a retirement plan can be excluded from gross income. He knew when he received the check from the plan that a rollover didn’t occur, and he used those proceeds for general living expenses. Thus, there was no reasonable cause (that is, no reliance on the advice of a tax professional), no good faith effort to comply with the tax laws, and accordingly, an accuracy-related penalty of $4,732 was due.